Sources of Russia’s Stagnation

Lack of investment, a deficit of trust of the private sector in the government, and a drain of migrant workers and professionals make it much harder for Russia to recover from its current economic malaise.

This is the second in a series of articles on Russia's economy by Andrey Movchan.

Anyone who seeks to stimulate the Russian economy into healthy growth will face a desolate landscape.

This is a situation that long predates the current economic crisis and a result of years of underinvestment and failure to adapt to changes in the global economy.

We can begin with Russia’s industrial production capacity, where there is a long history of underinvestment. Utilization of production capacity is nearly 85 percent, even at the currently modest levels of output. But a large part of Russia’s production capacity (more than 40 percent according to some estimates) is technologically and functionally obsolete, and many Russian-made products cannot compete in the world market, mostly because of the technological gaps and inefficiency of industrial equipment.

One reason for the decline is that the total machinery stock in Russia has shrunk by almost half over the past ten years, a problem that can only partly be explained by old, inefficient machinery being replaced by new high-tech equipment. A new spurt of economic growth requires accelerated capitalization of production and the creation of new capacity, but this is something that Russia simply cannot afford. This year the budget deficit is expected to exceed 3 percent of GDP, and it will most likely be close to 5 percent. State companies do not have the funds required, while private and foreign players are unwilling to invest because of the overall crisis of confidence in Russia.

Russia has fallen far behind its international peers in efficiency. This is the case when it comes to energy (Russia uses four times as much energy per dollar of GDP as Japan) and to logistics (the cost of transporting, storing, and processing goods through customs is on average higher in Russia than in other developing states, and even many developed states). This inefficiency has a negative impact on manufacturing costs, makes Russian goods less competitive, and prevents an increase in production and expansion of sales markets.

Moreover, Russia’s production capacity is also increasingly hurt by the fact that its labor pool is shrinking by 0.5 percent per year. Worse, much of the labor force is concentrated in sectors with very low or nonexistent value added, such as the civil service, law enforcement, private security, retail, and the highly inefficient banking sector.

There is a skills shortage, with a disastrous lack of engineers, technicians, and other skilled workers, as well as competent managers and administrators.

For years, Russia’s municipal services have been maintained through the exploitation of the labor of millions of migrants from neighboring states, most of them illegal. Until recently, cash remittances from workers resident in Russia were the main source of revenue for Kyrgyzstan, the second-largest source for Tajikistan, and a major component of revenue in Uzbekistan, Moldova, Ukraine, and Belarus.

But today, the number of labor migrants is dwindling because of the devaluation of the ruble and the decreased purchasing power of the Russian population. As a result, all businesses that rely on unskilled labor—particularly municipal services, but also the retail sector—are short of workers.

Inconsistent and illogical government policies have exacerbated the situation. There is not the solid legal framework on property rights, the economy, and entrepreneurship that could convince investors and businessmen both in Russia and abroad of its good intentions. Instead the impression is that the government is unreliable, unable to enforce laws fairly and consistently, hostile toward the business community, corrupt, and likely to prioritize state interests over private ones.

This lack of trust in the government has progressively turned businessmen from skepticism to departure from the country. Over the past 16 years, total capital flight has exceeded total revenues from oil and gas sales. The share of private business in GDP (not counting quasi-private companies effectively owned by individuals working for the state) has fallen to 30–35 percent. Foreign debt has dropped below 50 percent of GDP due to lack of interest in maintaining business development and subsequent divestment.

The Russian private sector is so undeveloped that it generates less than $3,000 per year per capita, a figure that puts Russia outside the top 100 countries worldwide in this ranking. The proportion of small and medium businesses in GDP is 20–22 percent, compared to 40–55 percent in developed countries. Yet Russian citizens and ex-Russians have bank account deposits totaling more than $1 trillion in banks in Switzerland and other European countries, as well as Hong Kong and Singapore.

That brings us to the brain drain. Every year, about 20,000–30,000 professionals and businessmen leave Russia. There are at least 6 million first- and second-generation Russian immigrants in the United States, 1.5 million in Israel, several hundred thousand in Great Britain, and at least 1 million in other European countries. As different statistics suggest, in all of those countries Russian-speaking workers earn at least 20 percent more than the market average.

Over the past few generations, Russia has lost about 10 million people (or approximately 7 percent of the population) that could have become the backbone of the middle class. Today’s middle class in Russia constitutes no more than the same number, 10 million people.

Hopes that the devaluation of the ruble may improve Russia’s long-term productivity are misguided.
Devaluation has certainly helped exporters, expanded the budget, and softened the worst of the economic shock. But it is unlikely to boost GDP growth. First of all, potential GDP growth in Russia depends almost fully on domestic demand, which is measured in rubles and is basically not growing. Eventually, growth in exports requires capital investment and technologies, neither of which is available at the moment

Moreover, in almost every sector of the Russian economy, production depends to some degree (anywhere from 15 percent to 80 percent) on the import of raw materials, parts, or equipment. The devaluation of the ruble is increasing the ruble-denominated prime cost of goods and even services faster than consumer demand is rising.

In conclusion, there is a complete crisis of confidence among entrepreneurs, professionals, and capital market investors in the Russian economy. The investment and business resources it needs are not there and will not appear unless and until Russia’s governance model undergoes radical change.